Recently I’ve noticed market commentators, the media and institutional investors starting to acknowledge not only the “synchronous global recovery” theme that we at Morgan Stanley’s Global Investment Committee were highlighting back in early 2016, but also the idea that corporate earnings are the main reason for the global equity rally.

As long as we see accelerating growth and stable financial conditions, equity markets around the world will likely continue to perform well. While investor sentiment is far from exuberant, we can say it's no longer negative.

All that said, the one part of our narrative that has yet to catch on is that inflation is not dead and may be stirring, getting ready for a more significant run next year.

Rising Inflation

Fixed income investors have essentially given up on inflation ever coming back since little upside risk of that happening is currently priced into interest rate markets. Even the Federal Reserve seems to be perplexed at why inflation remains so low in the face of full employment and an economy that seems to be doing just fine.

Everywhere I travel in the U.S., I see a boom as measured by the lack of open seats on airplanes, sold-out hotels and crowded restaurants, not to mention the almost out-of-control construction activity in every city. These are exactly the kinds of things that lead to inflation, but we aren’t in the business of guessing. Instead, we have leading indicators to help us navigate.

The year-over-year change in money velocity is our favorite indicator because it’s been quite accurate for more than 20 years. As the chart below shows, money velocity (dark blue line) typically leads core inflation (light blue line) by 21 months. It clearly predicted a precipitous fall in core inflation this year.

So, to hear institutional investors and even Federal Reserve officials talk about why they're perplexed about this year's drop in inflation actually confuses us. Many drivers of inflation work with a long lag, so focusing on current data can lead to some wrong conclusions. The good news is that our indicator is suggesting we are likely to see a near-term trough in core inflation before it ramps up into next year toward the Fed’s 2% goal.

The Importance of Inflation

You might be asking, "Why this is good news? Isn’t inflation a bad thing? Who likes higher prices?" Generally speaking, high inflation is a bad thing and for those of us who can remember the 1970s, we know how destructive it can be. However, inflation that is too low or outright deflation can be just as destructive—just ask Japan.

The other factor that must be considered is the fact that there is still a tremendous amount of outstanding debt in the world, especially at the government and corporate level. In such a world, deflation is like kryptonite. So, anytime inflation looks like it’s breaking lower—like this year—it makes global investors and markets quite nervous. Therefore, a signal that inflation is bottoming should be welcomed by global equity investors.

The other reason rising inflation is a good thing is that it suggests secular stagnation—a permanent, low-growth regime—is ending. Back in the summer of 2016 we took an aggressive stance that cited Brexit as an important bottom for growth and inflation expectations—that is, the end of secular stagnation. We viewed the enormous flight to safety immediately after the referendum as a final capitulation to this long-standing consensus view.

Because they are emotionally charged, political events have a way of faking out even the smartest investors. We view the election of Donald Trump in the same manner because U.S. markets understand this maxim quite well even if investors remain confused. Inflation expectations clearly bottomed with the resynchronization of global growth in February 2016. The affirmative Brexit referendum simply served to retest that bottom, but without new lows.

Reflation Part II Appears to Be Underway
(U.S. Five Year Inflation Breakevens)

Source: Nielsen Data, Morgan Stanley Research as of Oct. 12, 2017

Last fall, reflation became the rage as many governments focused on progrowth policies thanks to political pressure that culminated with the U.S. elections in November. As usual, investors then became too excited and bid inflation expectations too high, along with assets that benefit from higher growth and interest rates—i.e., banks, small-cap stocks, energy and industrials. After trading down in the middle part of the year, those assets reasserted their leadership in August and should continue to be good areas to look for further outperformance until the end of the cycle.

Note: This article first appeared in the October 2017 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

Risk Considerations

Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security’s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.

Ultrashort-term fixed income asset class is comprised of fixed income securities with high quality, very short maturities. They are therefore subject to the risks associated with debt securities such as credit and interest rate risk.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Credit ratings are subject to change.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.

Disclosures

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.

The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material.

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein.

The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Certain information contained herein may constitute forward-looking statements. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.

This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.

This material is disseminated in Australia to "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813).

Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities.

If your financial adviser is based in Australia, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Switzerland: Morgan Stanley (Switzerland) AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom.

Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.

This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC.

Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.

This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC.

Please be advised that the selection of the Financial Advisors presented to you is done randomly and is based solely upon areas of focus that have been selected by the Financial Advisors themselves and upon their stated preferences or interests. Morgan Stanley makes no representation as to an individual Financial Advisor�s experience and/or knowledge in the stated preferences or interests they have chosen. The preferences and interests that they have chosen have not been vetted by Morgan Stanley. Individuals are encouraged to consider their own unique needs and/or specific circumstances when selecting a Financial Advisor.